What Caused the Eurozone Crisis, & Does it Matter?

The outline of a future European monetary union less vulnerable to crises than the current Franco-German design is beginning to emerge. It will need a banking union, including centralised supervision and resolution, as well as some common system of deposit insurance to curtail destabilising runs. It will also need stronger bank equity with minimum non-equity capital that can be bailed in when banks get into trouble. Sovereign debt ratios are now so high that future rescues by national treasuries will simply not be feasible, so the cost of debt to European banks will unavoidably be higher. The monetary union could do with a common macroeconomic policy – Europe as a whole is almost as closed an economy as the US.

But getting to first base in a re-designed monetary union means sorting out the current mess, and the willingness to accept and distribute losses is absent, largely because of the persistence of the belief that the crisis was caused principally by fiscal excess, and that sinners should pay. Sinners in this case means debtors.

There have been numerous papers arguing that the origins of the crisis were not fiscal, but principally monetary. Here’s another one, with references to some more:

The European economy faces a re-building task on a scale corresponding to the aftermath of a (small) war. One of the lessons of twentieth-century European history is that allocating blame is not a good re-construction strategy after wars. The current impasse bears comparison to the ‘sinners should pay’ response to WW 1.

After WW 2, with lessons learned, the blame-game was avoided to a considerable degree. It does not matter (except perhaps to lawyers) what caused the mess. What is the feasible allocation of costs (infeasible allocations include pretending that the Greek default was big enough, for example) that offers the best prospects of economic recovery?

The costs have not all been incurred – failing to distribute the costs already incurred lets them grow.

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But I’d imagine people know my thoughts on the current system of money creation/destruction at this stage.

We’ve tried almost everything over the last 300 years to keep this system of money creation/destruction stable and yet 300 years after tweaking the system in every imaginable way we’re in the largest financial crisis of them all.

And still we are no closer to getting this system to be fit for purpose all the time. Looking right at the foundations of the system explains a lot:

Money comes from bank loans and so it’s created in parallel with an even higher debt.

Only the principal of the loan is created by the bank and from this the economy must repay the principal plus interest which means defaults are unnecessarily inevitable.

Money ceases to exist once a debt is settled with a bank so reducing our personal and business debts doesn’t leave us in a better position.

The other problem with this system is that if no-one is willing or able to get a loan from a bank the economy has no real source of money.

I just don’t see how a banking union, supposedly adequate reserves of non-equity capital and deposit insurance can bring stability to this system?

Full reserve banking would address many of the concerns raised in the post.

There could never be a bank run. There would be no need for deposit insurance. Finally, as explained below, there could never be a bank bailout again.

Under full reserve banking the money supply would be created without a corresponding debt at source. Banks could only lend existing money and as such it would be entirely possible for all loans to go according to plan. Even if there was a mass default on loans the risk of any loan stays between the bank and the investor and it wouldn’t even help the economy to have failed investments guaranteed by the taxpayer. Even if every bank somehow failed simultaneously under full reserve banking the money recorded in all current accounts would still exist in its entirety. Hence there would never be a bank bailout again.

Thanks for the post, I enjoyed the paper. Can I ask a question on the following extract:

‘With free capital flows and freedom of establishment for banks, these regional bubbles (and associated current account deficits) may be impossible to prevent, see Kraft and Galac (2011)’

Do you believe that there is a chance our bubble was impossible to prevent? Or do you believe it was entirely within our power to prevent? Could good regulation, proper fiscal policy and perhaps good use of mortgage/property taxes have prevented it (completely)?

Apologies if you’ve already stated your position on this. 5 years of consuming eurozone crisis analysis has left forgetful of positions.

Only if you wish to avoid the same thing in 70 years time. Kondratieff pointed all of this out long ago?

Making debt, via banks, vastly more than actual as opposed to paper, assets, with interest due, inevitably imposes massive burdens when eventually, demand for debt ceases. It always does, it always will.

When that happens, there is a scramble for those real assets to be taken out of the paper system allowing the economists etc to gain employment arguing about paper ….

There is going to be another seizure, a cessation of all trust, in months to come. That will mean that all the genuine assets, that do not represent someone’s debt, will have been taken out of this paper based system. Of course, much of the paper only exists as information, virtually, on a hard drive somewhere. Not worth much!

All this is known to students of economic history. What is different this time, is that the public are more credulous and have more to lose. That means the steps of crisis will be drawn out. This is what happened in Japan. It continues, as there has been no resolution by debt liquidation, except when UK national gets appointed as M-D!!

There have been numerous papers arguing that the origins of the crisis were not fiscal, but principally monetary.

The crisis has and still has very little to do with fiscal or monetary or even economic issues. The crisis was caused by crime. Criminals in the banks, in the finance industry, in government, in the media and in academia created, promoted, enabled, and defended a massive fraud. Their goal from day one was to gamble and give the bill to everyone else. This went back to at least 2003.

This is a crisis of the rule of law, or what little remains of it. It is not going to be possible to solve any part of this crisis while criminals are not only allowed to remain free, not only allowed to profit from their crimes, but are in fact openly rewarded, promoted, and given even more power.

Criminal Bankers, past and present, continue to laugh at the taxpayer paying their bonuses and pensions and openly scorn democracy and its elected representatives. They do this because they beleive, because they know they are above the law, beyond sanction, untouchable.

After WW 2, with lessons learned, the blame-game was avoided to a considerable degree.

Not so. The Nazi’s were tried at Nuremburg. Inquiries were held, injustices and barbaric acts were exposed, war crimes and the Holocaust were proven beyond a doubt. The guilty were exposed, and held to account for their crimes. Then and only then did the healing of the western world begin.

By the time this is over, we’re going to need a “Banking Nuremberg” to restore public confidence in western civilisation. I just hope we don’t need a “Banking World War” to get to that point.

Bankers did what they were paid to do: lend money on the basis that the government was fairly measuring the value of lands that were the main security. Building was to add value, so competent developers were doing their job also?

Government did not live up to the title. They donned the green Jersey, despite the drop in interest rates, on accession to the Euro. The cosy relationship with banks was not the cause. Lack of regulation and sensible reserve enforcement was the cause. Even a simple exercise in comparatives would show that the state was paying too much to servants and political dependance on planning permissions.

Banking is a weapon. Jefferson recognized this and the USA refused to have a privately owned central bank for centuries, falling in 1913. It requires corruption of laws, and the law forming process, to fully damage an economy, as happened in Ireland.

It’s hard to see a union like the US emerging — who’s in favour of federal social security or tax systems?

Some of the private imbalances up to 2007 spawned the public balances in that period.

Spain had an unemployment rate of close to 22% in 1997 and by early 2007, the property boom cut the rate to 8%. Public finances improved as in Ireland in response to the frentic activity.

One of the big developments in Europe in the past decade was the rising share of exports taken by the former Soviet-controlled countries such as Czech Republic, Poland, Romania and Slovakia – - a trend that had pre-dated their entry to the EU in 2004.

Italy grew at an average annual rate of 0.3% in the past decade and its shoe industry in particular was hit by imports from China and Vietnam.

Apart from proximity to Germany and lower costs in Poland etc, in terms of the supply of intermediate goods, there has been a closer complementarity with German manufacturers than in the countries of Southern Europe.

Germany accounted for a 27.7% share of ex-EU27 exports in 2011 compared with 10.7% for France, 10.6% for Italy, 4.7% for Spain and 11.5% for the UK.

The European Commission said last month: “In short, the increasing internationalization of the German economy remains to some extent a puzzle.”

The UK has just begun to export more to the BRICs than to Ireland.

It shows that despite its own currency, the UK needs to have companies producing products/services that can win customers elsewhere.

It’s not an easy situation to address — Peugeot Citroën for example will never outclass German cars in emerging markets.

Japan at one stage seemed to have the answer; now most of its big companies date from before 1975 and many of them are f-cked!

Like OMF says, the comparison with WWII is not valid. The perpetrators of war were punished. The German people suffered badly in WWII. The generous post war economic settlement does not create a moral hazard that this war mullarkey is a one way bet. Unfortunately solving a monetary crisis by wiping the slate clean does create a huge moral hazard for the future.

Where did it all go wrong? A fascinating question. Long time ago we had these sub prime thingies but are they really to blame? One thing for sure we see the frailties of a market based system. The market was wrong to lend to all banks and all countries on the same terms as they would lend to Germany. Is there a holy grail where all these human frailties are expunged? I don’t think so.

A very good paper with the central conclusion of which – bank bail-ins are a sine qua non – it would be difficult to disagree.

However, the time-scale chosen for illustrative purposes is too short. The story begins with Maastricht and covers two decades not one cf. Chart 5 in the July report of the German Council of Economic Advisers.

It usually takes a crash and its memory to temper excess: Asian countries today have low debt and prudent economic management after the experience of 1997/98.

Sweden has a sovereign surplus of 30% of GDP and Finland’s surplus is at 50% of GDP — after learning lessons from the early 1990s.

As for Ireland?

Historian Roy Foster says in his book ‘Luck and the Irish: a brief history of change from 1970‎,’ that in December 1977, Trinity College professor of economics, Martin O’Donoghue, who was then minister for economic planning and development, promised an “‘everlasting boom.” In 1978, a public spending fuelled boom in Ireland resulted in a budget deficit of 17.6% of GDP (gross domestic product) - – a record for developed countries according to the International Monetary Fund (IMF), for the period 1970-2008.

Foster terms O’Donoghue the Mephistopheles to his taoiseach Jack Lynch’s Faust but apart from the beginning of a period of reckless economic mismanagement, 1977 marked the entry to Irish national politics of Bertie Ahern, Charlie McCreevy and Mary Harney. Two decades later, on assuming power, the words of Frenchman, Prince Talleyrand,about the Royal Bourbons were apposite: “They have learned nothing and forgotten nothing.”

Some interesting stuff there. Does Finland really have a budgetary surplus of 50% of GDP?, I can’t begin to get my head around that one.

One hears the usual (is it Austrian school?) fanatics banging on about the evils of a our debt based monetary system. For sure it has its weaknesses rooted in human nature. But our monetary/financial system has played a not insignificant part in the enormous beneficial transformation in our economic condition in modern history.

I was referring to what the IMF terms net debt (debt less public funds such as for pensions) which is at -51.1% of GDP for Finland in 2012; the correct figure for Sweden is -17.5% and Norway is at -169.3%, thanks to its oil-related sovereign fund of over $500bn.

Yes, thanks to credit, life is no longer nasty, brutish and short for most of humanity.

It rules out an EA deposit insurance scheme. As to whether the Council’s proposed three pillars would include bank bail-ins, from a cursory examinaion of the text, this does not seem to be entirely ruled out.

‘Do you believe that there is a chance our bubble was impossible to prevent? Or do you believe it was entirely within our power to prevent? Could good regulation, proper fiscal policy and perhaps good use of mortgage/property taxes have prevented it (completely)?’

Briefly given Euro entry, and electing Bertie three times in a row, it is likely there would have been a pretty big bubble even if the regulators had done better (and been allowed to do better). Had we stayed out of the Euro, there would probably have been a bubble anyway – several non-Euro countries had excess credit expansion. But interest rates would have been higher, the bubble would likely have been smaller and there would have been broader policy options in dealing with it.

All blood under the bridge at this stage.

Michael Hennigan: It is not clear that a very extensive fiscal union is technically necessary for the monetary union to survive. Some common bond issuance perhaps, with a pan-European deposit insurance scheme and tight fiscal oversight might be enough. Deposit insurance need not be too costly with robust bank supervision, regulation and resolution.

I would suggest that the current crisis had its origin in the dramatic interest rate reduction introduced by George W. Bush after the attack on the World Trade Centre, in order to stimulate the USA economy and maintain growth. These low interest rates allowed for subprime mortgages in the USA and their failure resulted in American banks failure and European Bank contagion as they had purchased these products from American banks.

“Briefly given Euro entry, and electing Bertie three times in a row, it is likely there would have been a pretty big bubble even if the regulators had done better (and been allowed to do better). Had we stayed out of the Euro, there would probably have been a bubble anyway – several non-Euro countries had excess credit expansion. But interest rates would have been higher, the bubble would likely have been smaller and there would have been broader policy options in dealing with it.”

I would add to that the point that much of the appreciation in property prices would have been extinguished in favour of Punt appreciation – which would have itself cooled the economy (through reducing the attractiveness of Ireland as an exporter) much earlier. Similarly, much of the reversal in Ireland’s economic performance would have resulted in reversal of the Punt rally (ie depreciation) – so property prices would have had much of their adjustment achieved in international terms, by currency movements.

This analysis was readily available prior to Euro entry, but there were closed ears all round. Closed ears, that is, belonging to “whos” rather than “whats”.

“The European economy faces a re-building task on a scale corresponding to the aftermath of a (small) war. One of the lessons of twentieth-century European history is that allocating blame is not a good re-construction strategy after wars. The current impasse bears comparison to the ’sinners should pay’ response to WW 1..”

You sat in an RTE studio about two years ago and openly suggested to Matt Cooper that debt forgiveness in relation to Irish mortgage holders was a really bad idea. Moral hazard was all the rage and you were suckered in to its web. I can remember it very clearly because Matt was calling for NAMA (or an equivalent) for the little guy and you dismissed the idea without a seconds thought. I now know you could invoke the Keynes line about changing information and changing opinion etc but for me its too little too late. Your Damascene conversion is difficult to reconcile.

The underlying data and importantly the path the data was likely to take in relation to distressed mortgages was, even for non economists like myself, so blatantly obvious even five years ago let alone two years ago that I find your recent calls for Sovereign debt relief at odds with the far more important element in the debt debate namely the home grown household debt disaster.

The cynic in me tells me that deep down you don’t actually believe in debt forgiveness for distressed mortgage holders despite the shouting and banging the table for relief of Govt debt. You seem, like many economists, to believe in a parallel universe when comparing household and Govt/Sovereign debt. Its as if the Govt debt takes precedence. This is a nonsense economic stance.

Perhaps therefore you could state for the record your current view in relation to mortgage debt. You know deep down huge swathes of this simply cannot be serviced even with a significant dose of economic growth because by its very nature such growth is predicated on improved competitiveness, which is really code for falling labour rates. Falling labour rates is not a good mix for repaying likely rising mortgage costs nor is bankrupting hundreds of thousands of consumers as envisaged by the PIB.The PIB route assumes no wrongdoing on behalf of the banks – all the pain on the side of the novice consumer – and yet the entire banking industry in the RoI is insolvent. Can you perhaps explain how bankrupting the consumer with the same consumer having contributed to the survival of the retailer actually solves anything or indeed makes any sort of economic sense? I know I can’t.

Too much household debt is ALWAYS a bigger problem than Sovereign debt sustainability and its quite annoying to read the so called ‘experts’ awake Bagpuss fashion to its disastrous long term economic implications and yet still believe the route to salvation is to sort the Govts balance sheet first. I’m at a loss to understand the logic.

Perhaps to begin to recoup for lost time I suggest a crash course in the Steve Keen economic view of the world ASAP as he’ll set you straight on what is actually required. Rest assured Govts come after households in terms of debt relief.

What is not required at this juncture is ever-higher capital ratios for the European banks. If there was ever a template as to why this does nothing to solve the banking problem just have a look at the share price movements in the Irish banks since 31st March 2011 when the overcapitalisation was believed by Regulators et al to be a fire proof method to ensure proper functioning banks. Complete nonsense, the opposite is what is in fact required in the short term.

Nobody could argue that over the longer term higher capital equity ratios in a rising economic cycle are required but we’re so far off such a position that it is correct to suggest that the ongoing Regulatory regime is effecting the economic growth prospects and ensuring the upswing in the cycle remains a distant prospect. In Irish terms, the property collapse is already out of the genie loan loss bottle – why the need to pretend there are much further lending risks out there. We all know there may well be some but they are tiny in comparison to the property losses. So pray tell why the need to hold ludicrous amounts of capital for such a rainy day – its absolutely hammering down outside the banks doors and yet the Regulators continue to suggest more capital please. Bizarre. I stand by my suggestion that the Irish banks should exempt themselves for at least 5 years from the Basel III rules and then engage in a piecemeal fashion.

@grumpy
“What makes you limit the terms of reference of this question to “what?” and not include “who?”?”
You can’t have pretensions to ‘science’ and include individual, non-reducible actors… it is the singular failure of economics as a science, as it was of social ‘science’ before it.

Be gentle with the ontologically challenged as they dare not look in the mirror to address the beautiful complexity of human agency that their methods and propensity to acontextual and pseudo universalist neopositivism demands. Tenure quite often demands such sacrifices.

Behavioural economics is going in a superior direction ….. context, time, and key actors and decision makers matter here ….

@DoD
While behavioural economics has advantages in modelling groups of individuals, it tells us nothing about what specific individuals do. How do you model Merkel & Schauble? Or Bush and Cheney going to war in Iraq? How do you model madmen in planes?

So the punt, responsible economic governance and regulation could have mitigated the crash significantly, but not prevented the flow of credit or crisis completely?

I am the most critical of governments role in joining the euro so easily, fuelling of the madness and poor response to the crisis, but I feel like the question as to whether the system was going to flood the island with cheap credit no matter what was done, is an important one.

Aside from Euro entry, if the incompetence we’ve showed in the management of our own affairs was of no/minor consequence then it would be quit unfortunate considering our position of relying on the ‘kindness of strangers’ and discussing/begging regarding ‘attributing losses incurred’.

That there was incompetence is hardly at issue. But governments which sought to control credit aggregates have had difficulty in doing so. Free capital flows, an international liquidity bubble, freedom of establishment for banks, cross-border credit access for many, have all restricted the effectiveness of central banks.

The surveyors/auctioneers i.e the property professionals are an SRO i.e. a self regulated organisation which in Ireland means no regulation. These property professionals were responsible for four practices which created the monster property bubble ;

First the valuation error i.e valuing all 5 euro notes as 20 euro
Second the ruinous Irish commercial property lease law organised by a criminal cartel.

Third they controlled the commercial rent review/arbitration system which was systemically corrupt, with the use of secret agreements,side agreements, straw tenants and other chicanary widespread.. The decisions of these arbitrators were absolute ,with no right of appeal on the rent they determined to any court in the world. They had more power than a Irish Supreme Court judge or any judge in the world
And fourth,ninty five per cent of all property sold in the state is sold by surveyors/auctioneers.
They controlled where the property advertising money was spent. Almost all of it was spent with the broadsheet media and the Irish Times, the mouthpiece for the property industry and owner of MyHome.ie, got the lion’s share. These property professionals. controlled the Irish Times property propaganda and all the other broadsheet media property propaganda. They had enormous influence in these papers editorial policies.

This fourth item was the fatal one–the media faciltated this propaganda. There were other useful idiots like the soft landing economists etc etc.

The economics of your paper, insofar as I can judge, are sound. The politics, on the other hand, seem to me to be open to question.

It is, indeed, “all blood under the bridge” at this stage. The mess that each country made of its affairs is its own mess and there is no way that Germany is going to accept any responsibility other than that which relates to the maintenance of the euro. There are possibilities in this context. All the rest is froth.

Thanks for that @rf, interesting read. Still, the point remains that while an event may be modelled as more or less likely, the timing of it often rests with specific individuals or chains of individuals – hanging Chad (the poor fellow), mad folks in planes, ex-oil company execs in the Whitehouse…

@Dod, if you cannot model their effects, you cannot model anything. It is not about predicting the past, any fool can build a model to do that. It is about the much harder subject of predicting the future. Babble, most of it, economics included.

Looking to the future, one of the possibly overlooked benefits of the Obama victory is that it may strengthen the hand of Cameron in deciding to follow a more sensible European policy. (Merkel in her speech to the EP remarked that she could not imagine an EU without the UK).

Was it ‘not permitted’ or as (could be wrong on this) Michael Somers alluded to, did we twiddle our thumbs for 12 months after the warning bells starting sounding? Time we could have spent establishing a proper resolution regime? Or would that, to your mind, have made a difference? A genuine question?

Also, in your opinion was our crisis 100% within our power to prevent? I.e if we had been more fiscal prudent, had higher stamp duty, had a strong bank resolution regime in place, had proper bankruptcy law, mortgage loan to value and multiple income loan limits, only 25 year fixed term mortgages allowed etc etc surely then their would have been no crisis?

Was it impossible for us to impose credit restrictions though? I mean, 20% deposit required, 4 times salary limits etc etc… If action like that was taken in the early 2000s in response to the warnings would that not have cooled/cured the bubble?

Or is that too much to expect from any government in the face of a credit junky electorate?

Or would the credit have found a way in regardless? Banks in other states offering mortgages etc etc?

The radicals in academic finance would revamp the basic metric of economic performance. The familiar statistics on gross domestic product would be coupled with an index of financial risk-taking, so that the usual focus on growth would be tempered by a measure of the danger that growth might suddenly implode. This month of all months, one craves an equivalent risk-weighting to reflect political uncertainty. Amid the marathon reality show of the American elections, the tense theatre of the Chinese transition and the anarchic agitprop of eurozone politics, non-risk-weighted economic forecasts verge on irrelevance. Even with the US election behind us, this is not about to change.

Free capital flows, an international liquidity bubble, freedom of establishment for banks, cross-border credit access for many, have all restricted the effectiveness of central banks.

In some ways yes. But in others they have strengthened their influence, particularly when central banks act in concert.

Where can investors displeased with the current monetary order place their money? They have more freedom, liquidity, and options than any generation before them, yet what are their options really? The US, UK, Europe, Japan are all false choice between virtually identical options. Even the Swiss have begun to move in step with the big four.

The world economy increasingly resembles the crowds that crossed the Millenium (“Wobbly”) Bridge in London some years back, forced to march in step by inherent flaws in the structure’s design. Though the world economic system appears to be heading for a Tacoma Bridge endgame.

Regarding the original title of the post Adair Turner, the chairman of the UK’s Financial Services Authority, member of the BoE’s Financial Policy Committee shared his views on the cause of the financial crisis in his speech to the South African Reserve Bank on Friday 2nd Nov 2012:

“The financial crisis of 2007/08 occurred because we failed to constrain the private financial system’s creation of private credit and money.”

He also noted that:

”Banks which can create credit and money to finance asset price booms are inherently dangerous institutions”

Prosperity feeds on itself creating a virtuous circle where people begin to believe that businesses cannot fail and property will continue to appreciate. At the height of property booms people fight in the front yard demanding to be able to put in a higher bid. When the bubble bursts prospective buyers become hard to find as the negative circle unfolds.

Availability of low interest loans is the crucial ingredient. The core and Germany in particular was the source of low interest short term money for our banks. Our banks marked up the rate and lent long to a substantial number of customers. A Gov’t, Central Bank, Bank Regulator and managers of retail banks that were asleep at the switch aided and abetted the fiasco.

The solution as David Dodge ex Governor of the Bank of Canada stated will unfold as follows. Germany, Holland, Finland in Europe and the US Congress in the US will only take action when hanging at dawn is imminent and then at about 3:00 a.m..

He insists that economists in the countries running surpluses are advising their Gov’ts on the correct course of action and self serving political intransigence is the root problem.